In order that the financial system avoid another meltdown, Senators Brown and Vitter want the big banks to operate at a 15% capital ratio. The editorial writers at Bloomberg have decided is should be more like 20%. Anat Admati, the new patron saint of the bash-the-big-banks crowd, thinks it should be as high as 30%. Do I hear 40%?
Bank skeptics seem to have gotten the notion into their heads that if only banks’ capital levels were high enough, the risk of a replay of the 2008 crisis would effectively fall to zero, and all would be well with the world. Baloney. At the depths of a financial panic, it’s not inadequate capital that usually dooms banks, it’s inadequate liquidity. If you doubt it, let’s play a mind game. Let’s pretend it’s September 2008 again, you’re in charge of overnight lending at a large financial institution, and the fellow from Lehman Brothers is on the phone. The Bloomberg editors’ wishes have preemptively come true and Lehman’s equity ratio is a plump 20%. Would you provide Lehman with another day’s worth of funding?
Spare me the bravado; no, you would not. Why? Because in those panic-pitched days, no one had any idea what Lehman Brothers’ underlying assets were worth and, to be on safe side, people chose to assume the worst. Sixty cents on the dollar? Fifty cents? The basement was the limit! The losses implied by those numbers would have swamped even the mightiest balance sheet. More important, even if you thought you had a handle on the matter (which you did not), you weren’t sure Lehman’s other lenders did, so that in the worst case, you’d provide the overnight funding while the others held back, and Lehman would blow up anyway, only with your money and nobody else’s. Smart career move! Thanks anyway, but you’d pass.
Moral of story: in the midst of a panic as severe as the one the would-reformers are seeking to prevent, no amount of capital is enough to douse the fears of nervous lenders. Should banks hold adequate capital? Of course they should. But there’s a limit to what’s sensible and economic, and we’re already long past that point. Since the panic has passed, banks have been forced to bolster their balance sheets to such a degree that, at most institutions, the optimal use of the marginal dollar of capital is to simply return it to shareholders via dividends or buybacks. Adequate investment returns simply aren’t there to be had.
Nosebleed levels of capital don’t solve the problem. Rather, ensuring adequate liquidity is a much more crucial safeguard of solvency. As far as that goes, liquidity risk has been much reduced with the promulgation of Basel III.
In the meantime, this notion that boosting capital requirements would have no macroeconomic effect (“Such a requirement wouldn’t harm economies,” as Bloomberg blithely puts it) is idiotic on its face. In a note to clients Monday, my pal Dick Bove points out that, to achieve the capital levels Bloomberg has in mind, the banking industry would have to add $1.26 trillion in equity. It could either raise the $1.26 trillion via equity offerings (and good luck with that), shrink assets by $6.3 trillion, or do some combination of the two. Given the equity raises banks have already had to do in recent years, banks would mostly shrink. If you think the banking industry can collectively deleverage by $6 trillion without crimping the creation of credit, you really do need to be in a different business.
I have news for the people who are seeking to reform the banking industry: no matter what bright ideas you come up with, you’re not going to remove all the risk from lending. (And if you do, the business will be worthless.) And as long as there is risk, there’s the risk of bank failure. What’s needed aren’t schemes that would prevent failure under any circumstance (those won’t work), but rather a practicable plan to handle failures of any size that would treat creditors fairly and keep taxpayers out of the picture.
In the meantime, the best risk protection is the one that’s the most time-tested and, ironically, the one the reformers resist: diversification. It is no accident that the big banks that came through the crisis the best, JPMorgan Chase and Wells Fargo, are the ones that didn’t go crazy on mortgage lending and have a broad range of income streams, from asset management, to market-making, to, yes, mortgage lending. When the mortgage business went down in flames, the other businesses were there to pick up the slack. Yet now reformers propose that banks shed many non-core business and become more dependent on lending than ever. How this is supposed to make the system safer and more stable is beyond me.
There are ways to take some of the risk out of the financial system. Congress might, for example, repeal that cussed Volcker Rule. Unfortunately, the ideas being thrown around that are getting the most attention would likely make the system less safe, rather than more so, and would slow economic growth, to boot. That’s not my idea of a helpful solution. Senators Brown and Vitter, Professor Admati, and the writers at Bloomberg have got things all wrong.
What do you think? Let me know!